Director-General of the Research Bureau People's Bank of China

In December 1978, exactly 25 years
ago, China's economic leaders began their journey from central
planning to free markets. A long march at a sprinter's pace, the
process of economic change in China has been nothing short of
breathtaking.

In just a quarter century, China has grown from virtual autarky
to the world's fifth largest trading partner and largest recipient
of foreign direct investment. From 1978 to 2001, its gross domestic
product grew from one-eighth to over half that of the United
States, making China the world's second largest national economy.
Within a dozen years, by some estimates, it will be the world's
largest.

The results are globally apparent. Chinese skirts fill malls
in Muncie; American franchises sell burgers in Beijing; European
and Japanese manufacturers are investing billions on production
and research facilities in China's largest cities; Chile's copper
exports to China have soared. And months ago, China shot into
orbit with its first manned space flight—only the third
nation on earth to do so—a mark of political determination,
scientific prowess and economic vigor.

The People's Bank of China, the nation's central bank, has been
a key—if obscure—actor in this remarkable transformation.
And in coming years, the PBOC is likely to play a still more
critical role as the nation's financial sector opens up to international
competition, as state-owned banks address their bad loan troubles
and as world leaders exert continued pressure on China to revalue
its currency.

In March 2003, the Minneapolis Fed's Art Rolnick met with PBOC
director-general of research, Ping Xie, in Beijing and there
began an extended conversation about China's central banking
practices and policies. The exchange printed below was conducted
in writing, with questions and answers traded over a number
of months. Mr. Xie's comments, translated from Chinese, cover
issues ranging from central bank structure and interest rate
liberalization to deflation and deficits. It is a rare glimpse
into the complex state of affairs of the world's most dynamic
economy.

Central Bank Structure

Rolnick: In the United States,
our Federal Reserve System comprises 12 regional banks and 25 branches
under the oversight of the Board of Governors. The regional banks
are the operating arms of the System and they also conduct research,
and their presidents attend meetings of the Federal Open Market Committee,
which establishes monetary goals for the country. For our understanding,
could you briefly describe the structure of the People's Bank of China?
Does it have regional banks, for instance, and which unit of the PBOC
sets monetary policy?

Xie: The People's Bank of China comprises nine regional
banks, 328 central branch banks and 1,811 county branch banks. Before
1998, regional banks of the PBOC were located in each province—that
is, every province had a separate regional bank, whose business was
susceptible to intervention by local government. In 1998, this was
changed. Nine regional banks were established in nine relatively developed
provinces, and each of them supervises two to five provinces. The
goal of this reform is to strengthen the independence of the PBOC
to carry out monetary policy, and financial control and management.
This past April, the China Banking Regulatory Commission was newly
created specifically to manage deposit financial institutions. The
PBOC will no longer oversee these kinds of institutions. This reform
changed the functions of the PBOC but didn't affect its overall structure.

There is a Monetary Policy Commission inside the PBOC, chaired by
the governor of the PBOC. The members include [officials from] the
Ministry of Finance, State Development and Reform Commission, Securities
Regulatory Commission, Insurance Regulatory Commission, main financial
institutions, State Administration of Foreign Exchange as well as
academic experts. The Monetary Policy Commission is not a decision-making
body, but a consulting institution. It has one regular meeting every
quarter and provides advice on monetary policy. It is the Monetary
Policy Department inside the PBOC [not the Commission] that is in
charge of issues related to monetary policy.

Central Bank Operations

Rolnick: As you know, the Federal Reserve manages
the money supply largely through its open market activities. Could
you explain the mechanisms that China uses to inject money into the
economy? To what extent is it accomplished through fiscal policies
rather than central bank mechanisms?

Xie: The People's Bank of China has gradually changed
from direct control to indirect control of the macroeconomy. In 1998,
it ended controls on loan limits. Currently the PBOC utilizes a combination
of central bank loans, rediscounting, open market operations, interest
rates, exchange rates and lending policy to control the macroeconomy.

In the first half of 2003, the growth rate of M2 increased by 20.8
percent, the highest since 1998. The total amount of new loans was
renminbi (RMB)1.8 trillion and the growth rate was 22.9 percent. The
foreign reserve balance was US$346.5 billion. And base money increased
by RMB387.6 billion. To maintain economic stability and prevent financial
crisis, the PBOC adopted appropriate counter policies. Through open
market operations in the first half year, the PBOC withdrew RMB277.8
billion in base money. On Sept. 21, the PBOC increased the deposit
reserve ratio from 6 percent to 7 percent. Assuming the deposit balance
is RMB15 trillion this year, we will withdraw about RMB150 billion
in base money.

Fiscal policy and monetary policy are two important tools used to
control the macroeconomy. Our fiscal and monetary policies are independent
but also coordinated with one another. After 1998, in order to increase
domestic demand and support the economy's steady growth in the context
of a declining consumer price index (CPI), China decided to implement
proactive fiscal policies and sound monetary policies. Since May 1996,
the PBOC has decreased the interest rate on deposits and loans eight
times. In terms of fiscal policies, from 1998 to 2002, China issued
government bonds in the amount of RMB660 billion in total, which were
mainly used to finance infrastructure. Evidence has shown that the
coordination of fiscal and monetary policy is crucial for supporting
steady economic growth. In recent years the growth rate of gross domestic
product (GDP) has remained steady at about 8 percent per year.

Central Bank Independence

Rolnick: In the United States, we go to great pains
to preserve the independence of central bank policy and practice.
Given a very dissimilar history and political structure, I imagine
the situation might be quite different in China. To what extent is
the People's Bank of China truly independent from the fiscal authorities
that make tax and spending decisions?

Xie: China and the United States have different political,
economic and historical situations, which are reflected in the independence
of their respective central banks. The independence of the People's
Bank of China is greatly different from that of the Federal Reserve
System of the United States. When we talk about independence of the
central bank, we mean the relationship between the central bank and
the government. It is believed worldwide that central banks should
maintain relatively high independence. I agree with this. But from
another point of view, independence is relative. Absolute independence
does not exist. In China, the PBOC has partial independence. The PBOC
is one of the departments under the State Council. Interest rate and
exchange rate policy must be approved by the State Council. The PBOC
decides other monetary policies independently. According to the People's
Bank of China Act [of 1995], the government can't overdraft from the
PBOC.

Exchange Rate Policy

Rolnick: For some time now, the yuan (or renminbi)
has been in a "managed float" relative to the dollar,
trading in a narrow band of 8.27 to 8.28 yuan to the dollar. China
has faced criticism for this—some argue that the yuan is undervalued,
and others say it is overvalued. But both these perspectives imply
that the exchange rate should float freely, rather than being managed
in such a narrow range relative to the dollar.

What is your perspective on the best policy regime: fixed or floating
rates? And what is the likelihood of allowing the yuan to float—or
at least to widen the band in which it trades—in the near future?

Xie: Since unification of the two-track exchange
rate in 1994, we have implemented a managed float exchange rate based
on market demand and supply. The renminbi exchange rate is basically
determined by the market. After the unification, the renminbi exchange
rate is relatively flexible, changing with respect to different currencies
to varying extents. Therefore, the renminbi exchange rate is flexible,
not fixed. Overall, the renminbi is appreciating relative to the currencies
of China's main trading partners. From the beginning of 1994 to the
end of 2002, the nominal appreciation rates of the renminbi to the
dollar, euro (German mark before euro) and yen are 5.1 percent, 17.9
percent and 17.0 percent, respectively. In real terms, the appreciation
rates are 18.5 percent, 39.4 percent and 62.9 percent, respectively.

Since 1998, the nominal exchange rate of the renminbi to the dollar
has been stable with little fluctuation. There are special reasons
for this narrow float band. In 1997, the Asian financial crisis broke
out and spread continuously. Many East Asian country currencies depreciated
greatly, which increased expectations of a drastic renminbi depreciation.
The government of China promised no renminbi depreciation, increased
control over the exchange rate and thereby successfully maintained
the stability of the renminbi exchange rate. This contributed to the
stability of Asia's—and even the world's—economic and
financial systems. After the Asian crisis, China continued its stable
renminbi exchange rate policy. In fact, the stability of the renminbi
contributes to the sustainable and steady development not only of
China, but also of surrounding countries and, fundamentally, to world
economic stability and growth.

Recently, international groups [including international agencies,
foreign governments and businesses] have begun to pay attention to
the renminbi exchange rate. The Chinese government has been very prudent
on this matter. It is worth pointing out that some arguments about
the renminbi exchange rate are obviously not well-grounded. The renminbi
exchange rate won't be revalued in the near future.

From this point forward, we will adapt to the evolving international
situation and explore and improve the renminbi exchange rate mechanisms
under the prerequisite of a stable exchange rate. We will actively
facilitate trade and investment, increase marketization of exchange
rates, develop foreign exchange markets, deepen and widen the reform
of exchange rate markets, use better methods in managing exchange
rates, coordinate interest rate policy and exchange rate policy, develop
money and capital markets, speed up the appropriate reforms and promote
the coordination of the internal and external economy.

Hong Kong

Rolnick: As a follow-up question, I'd like to ask
you about Hong Kong, which has its own currency. How long will it
be before there is a single currency for all of China?

Xie: This situation [of one country with two different
currencies] will last for more than 50 years. According to the Basic
Law of Hong Kong, Hong Kong's social and political policies ... will
not change over the next 50 years. The government of the Hong Kong
Special Administrative Region has a highly independent monetary policy
and exchange rate policy.

The Hong Kong Special Administrative Region government has no intention
of changing the current system of a linked exchange rate [between
the U.S. dollar and the Hong Kong dollar]. Although there are some
unofficial and academic debates about the exchange rate system, both
the mainland and Hong Kong governments have not put these questions
on the agenda.

Banking Regulation

Rolnick: Four major Chinese banks—the Bank
of China, the Industrial and Commercial Bank of China, the Agricultural
Bank of China and the China Construction Bank—have been in serious
financial trouble for some time now; official estimates are that they
carry bad debt equal to about 25 percent of their loans. Until recently,
the People's Bank of China has been considering whether to create
a rescue package for those banks; now that policy consideration will
likely be shifted to the newly formed China Banking Regulatory Commission.

But rescuing banks in distress—while helpful to the banks and
initially stabilizing for the economy—can create the perception
that some banks are too big to fail, and the problem of moral hazard:
the idea that banks will continue to take undue risks in the belief
that they will be bailed out. These are problems that have long been
concerns for policymakers at the Federal Reserve System in the United
States.

I'd be interested to learn your perspective on this issue. How should
bank regulators balance the need to deal with banks in lending trouble—and
the possible spread of panic should they fail—with the need
to prevent the perception that the government will always come to
the rescue?

Xie:The bad debt of China's bank system
After almost eight years of hard work since the Chinese banking management
meeting in 1995 first proposed that the bad debt of the four state-owned
commercial banks be lowered, financial management departments and
all commercial banks have achieved a remarkable level of success.

At the end of 2001, the balance and the ratio of bad debt of the four
state-owned banks decreased for the first time: The bad-debt balance
decreased by 90.7 billion yuan relative to the beginning of the year,
and the bad-debt ratio decreased by 3.81 percent.

At the end of 2002, the bad-debt ratio of the four state-owned commercial
banks was 21.41 percent, a 3.95 percent decrease from the beginning
of the year; the bad-debt rate of the 11 joint-stock commercial banks
was 9.5 percent, a 3.44 percent decrease from the previous year; the
bad-debt ratio of the 111 city commercial banks was 17.7 percent,
a 6.33 percent decrease from the beginning of the year.

At the end of June 2003, the bad-debt ratio of the four state-owned
banks (according to the five-category assets classification) was 22.19
percent, a 4.02 percent decline since the beginning of the year*;
the bad-debt ratio of the policy banks was 18.61 percent, down by
1.18 percent; the bad-debt ratio of the joint-stock commercial banks
was 9.34 percent, a 3.15 percent drop; the bad-debt ratio of the 112
city commercial banks was 15.88 percent, a 7.18 percent decrease relative
to the same period in 2002, which achieved the first-stage objective
of decreasing the bad-debt ratio.

However, the bad-debt ratio of Chinese banks is still relatively high.
The international consensus on a warning level for bad-debt [to total
debt] ratio is around 10 percent.

In 1999, to reduce risks associated with the nonperforming loan
situation in the Chinese banking system, China established four
asset management corporations (AMCs), which specialize in buying,
managing and disposing of the nonperforming loans of the state-owned
commercial banks.

The AMCs bought about RMB1.4 trillion of nonperforming loans of
the state-owned commercial banks, in accordance with the purchasing
limit set by the government. They then began to dispose of these
nonperforming loans according to commercial standards. The methods
of disposal include leasing, contracting-out, restructuring, debt-equity
swaps, holding security claims of the firms temporarily, transforming
assets into securities, etc. As of the end of June 2003, the four
AMCs had disposed of RMB361.841 billion of nonperforming loans (excluding
debt-equity swaps undertaken for policy reasons), had withdrawn
capital in the amount of RMB112.532 billion, and had taken back
RMB79.229 billion in cash through auctions in domestic and international
markets, joint ventures, restructuring and many other innovative
methods.

2. Disposition methods for nonseparated bad debt.

Although four AMCs were established to dispose of the nonperforming
loans of the Big Four state-owned commercial banks, they haven't
eliminated all NPLs. Currently, their NPL balance remains rather
high. The Big Four have designed a professional disposal method
to decrease NPLs through emphasizing their cleanup and management.

On Jan. 1, 2002, China expanded the five-category loan classification
management system to the entire banking industry to guarantee accurate
loan quality statistics. In 2002, four state-owned commercial banks
and 11 joint-stock commercial banks were in the early stages of
adopting the five-category system and using it on a daily basis.
The Banking Regulatory Commission has announced that the five-category
loan classification system will be fully adopted in 2004, and the
previous loan classifications will be abolished.

2. Actively disseminate prudent accounting systems; clean up NPLs
and nonloan assets according to prudent accounting standards and collect
interest according to related rules; increase bad-debt reserve ratios;
speed up the elimination of bad-debt loans; strengthen control of
the capital sufficiency rate of commercial banks; and strengthen capital
controls. The ratio of nonperforming loans to total loans must drop
2 percent to 3 percent each year for the bad-debt ratio to decrease
to 15 percent by 2005.

3. Strengthen loan management and avoid the emergence of new nonperforming
loans.

Commercial banks should: Improve their authorization and loan
examination mechanisms; establish and improve their systems for
bank inquiry and registration, and credit risk evaluation; terminate
lending to high-risk customers in a timely manner; gradually improve
loan management by separating the supervision and loan-granting
systems, and by investigating loans carefully; improve the accountability
of loan clerks and create effective incentives for them; examine
the granting and repayment of loans and ensure good quality of new
loans.

In sum, maintain the stability of the economy by lowering the nonperforming
loan ratio gradually in the process of supporting the growth of the
economy and banking development; speed up the reform of state-owned
enterprises and adjustment of the economic structure; eliminate the
source of nonperforming loans; prevent moral hazard; establish a good
credit environment; punish firms that default on their debt; improve
the legal system to protect lenders' interests; deepen the reform
of state-owned commercial banks; and increase the risk management
capacity of commercial banks. At the same time, insist on early risk
identification as well as risk warning and control, and, in particular,
monitor risk control and management inside banks.

The People's Bank of China will fulfill its role as a central bank
in controlling the macroeconomy and avoiding financial risks. At the
same time, it will strengthen its functions in formulation and implementation
of monetary policy, and continuously improve rules for related financial
institutions and improve financial macro control policies. The PBOC
and the Banking Regulatory Commission will establish a close relationship,
share information on financial market risks and operating situations
in a timely manner, and together maintain the safety of the financial
system.

Interest Rate Liberalization

Rolnick: Under traditional planning practices,
China has set benchmark lending rates with little or no flexibility
for banks or other financial institutions to vary interest rates according
to their assessment of the lending risk involved. China's one-year
yuan term deposit, for example, is set at 1.98 percent with no variation
allowed.

But the People's Bank of China has identified "progressively
pushing through reform of the interest rate regulatory regime"
as a necessary task in sustaining economic growth. What steps will
the PBOC take to reform the interest rate regime?

In that regard, could you tell us about the experiments you have conducted
in rural counties with flexibility in lending rates? Will this experiment
be expanded?

Xie: The objective of market-based interest rate
reform is to establish an interest rate formation mechanism in which
market demand and supply decide the deposit and loan rates of financial
institutions. The People's Bank of China will control and adjust the
market rate using monetary policy and make the market play a critical
role in the allocation of financial resources. The basic rule of the
reform is to deal correctly with the relationship among market-based
interest rate reform, the stability of financial markets and the healthy
development of financial institutions to properly coordinate domestic
and foreign interest rate policy, and to gradually reduce the fiscal
role of interest rate policy. The steps of the market-based interest
rate reform are: first foreign currency, then domestic currency; first
lending, then deposit; first long-term, large-deposit, then short
term, small-deposit.

In recent years, the PBOC has tried to carry out market-based interest
rate reform by widening the float ranges for both deposit and lending
rates at financial institutions and by decentralizing authority over
interest rate float; at the same time, the PBOC has improved interest
rate management. In 1996, the borrowing rate between banks was freed
from government control so that the rate depended on market demand
and supply; then interest rates on discount and rediscount notes and
interbank loans were freed up and policy-oriented financial debts
and government bonds were issued by auction.

The interest rate reform plan allowed the float scope of financial
institution lending rates to widen gradually, and financial institutions'
independence in determining the interest rate was also increased gradually.
For example, the lending rate float range for loans to small or medium-sized
firms was widened, as it was for county financial institutions and
rural credit cooperatives. Insurance companies with over RMB50 million
and CD terms longer than three years use interest rates determined
by agreement between the company and the customer.

In September 2000, three reforms on foreign currency interest rates
were implemented. Under these reforms, foreign currency lending rates
are decided independently by the financial institution; foreign currency
small-deposit rates are first discussed by the banking union and then
approved by the PBOC; and for deposits of more than RMB3 million in
foreign currency, the interest rate is determined by agreement between
the commercial bank and the customer. On July 1, 2003, we also loosened
controls over rates for small-deposit accounts in three currencies:
the pound, Swiss franc and Canadian dollar. Currently, only the small-deposit
rates for the U.S. dollar, euro, Hong Kong dollar and yen are regulated
by the PBOC.

In recent years, county financial institutions, especially rural credit
cooperatives, have been the main focus of China's market-based interest
rate reforms. In 1998, we increased the upper limit for lending rates
at rural credit cooperatives from 40 percent to 50 percent; in 1999,
lending rates at the county financial institutions were allowed to
float up to 30 percent. At the beginning of 2002, eight county and
rural credit cooperatives experimented with market-based interest
rate reform; the lending rate float band was widened from 50 percent
to 100 percent, the deposit rate float was increased up to 50 percent.
In September [2002], the reform trial was expanded to every province
other than municipalities directly under the central government. Wenzhou
City also has implemented interest rate reform.

As stated in the "Trial Act Regarding the Deepening of Reforms
at Rural Credit Cooperatives" issued in June 2003, the experimental
rural credit cooperatives "in the districts with active private
lending and borrowing are allowed to use a flexible interest rate
policy in which rates can float around one to two times the basic
lending rate. The lending rate is not allowed to increase for small
loans to farmers, but may float up for high-risk loans and float down
for rural people in disaster areas."

The experience of these rural credit cooperatives will be reviewed
and assessed continuously and be expanded under some conditions.

Rich-Poor Gap

Rolnick: The widening income gap, especially between
China's cities and countryside, has become an increasing concern for
Chinese policymakers, with Premier Wen Jiabao expressing his desire
to relieve the hardships faced by farmers and others in rural areas.
This concern arises in part because urban incomes have grown faster
than those in the countryside, and per capita income is three times
higher in cities. This has in turn led to increased rural-to-urban
migration.

Will the People's Bank of China play a role in addressing these concerns?
Are the rural lending experiments you've just described expected to
help conditions in the countryside?

Xie: In recent years, the People's Bank of China
has played a vital role in coordinating central government policy
to support agricultural development and the rural economy and to increase
farmers' income.

First, a series of credit policies has been introduced to increase
credit and lending to the agricultural sector, to improve rural financial
services, to boost farmers' income and to comprehensively manage the
rural credit project. Since 1998, the central bank had published successive
issues of "Instructions about the Current Rural Credit Project"
and related documents to request the financial system to accomplish
the following tasks: Guarantee credit sources to agriculture; increase
credit inputs toward agriculture infrastructure, technology improvement
and purchase of agricultural byproducts; strengthen the management
of loans to help the poor; improve rural financial services; propose
that the rural finance organizations follow a system that respects
geographic regions while permitting flexibility in the provision of
credit; expand the scope of credit in accord with the reasonable needs
of farm households; better serve farmers; support agricultural development,
farm product processing and agricultural industry management; and
simultaneously emphasize that rural credit cooperatives may provide
credit loans, as well as rural housing loans, education loans and
consumption loans.

Second, extend small credit loans to farmers and increase credit inputs
to farmers and agricultural production. Third, increase investment
in infrastructure for agriculture.

The PBOC also uses refinancing to improve credit for the agricultural
sector. From 1997 to December 2002, the total amount of refinancing
was RMB123.6 billion. This refinancing focused on the agricultural
provinces, the midwest region and the regions hit by natural disasters
to effectively relieve their capital needs. This also played an important
role in supporting rural credit cooperatives to grant small credit
loans and joint loans for farm households. In the past few years,
89 percent of rural credit cooperatives started small credit loans,
49 percent started joint credit loans and 25 percent of farmers received
either small credit or joint credit loans.

Furthermore, the PBOC grants discounted development loans to poor
areas and to farmers. From 2000 to 2002, the Agricultural Bank of
China granted loans totaling RMB76.7 billion to help farmers prosper,
to support the industrialization of agricultural enterprises and to
bolster infrastructure construction, educational projects and zoological
tourism projects. These loans have encouraged additional investment
of RMB174.1 billion and have lifted 4 million people out of poverty.
At the end of first quarter 2003, the total outstanding loan balance
of the Agricultural Bank of China was RMB92.9 billion, of which RMB47.9
billion was in discount loans.

The rural credit cooperative is an important part of the financial
system in China. It is the main resource for agriculture, the rural
economy and farmers. Currently, the reform of market interest rates
in rural credit cooperatives has increased the float band for both
deposit and loan interest rates. This helps rural credit cooperatives
attract deposits, organize capital, prevent rural capital from flowing
to the cities, utilize capital efficiently, enhance development capacity
and finally, increase credit to agriculture and the rural economy
and improve the income levels of farmers.

For the urban poor, the People's Bank, together with related ministries,
has devised another initiative: "About Measures of Supervising
Small Credit Loans to Persons who are Laid Off or Unemployed"
to expand small credit loans and support reemployment.

Monetary Policy—Is Deflation A Concern?

Rolnick: China's consumer price index has fallen
in four of the last five years, dropping 0.8 percent in 2002, for
a cumulative five-year CPI drop of 3.1 percent. Are you concerned
about this persistent deflationary trend? How do you explain such
deflation in light of the fact that your economy has grown so rapidly
and your money supply has also expanded at double-digit rates in recent
years?

Xie: This question includes three aspects: how to
understand deflation, how to understand Chinese deflation and the
relationship between money and economic growth.

First, how to understand and define deflation. Usually deflation is
defined as a sustained decrease in the price level. We need to pay
attention to three points in understanding deflation. First, the choice
of price indices. The major price indices are the consumer price index
(CPI), wholesale price index (WPI), and gross domestic product (GDP)
deflator. It is commonly believed that the GDP deflator is the best
index to determine whether deflation occurs. But China doesn't compile
data to calculate the GDP deflator. Since the CPI is a better measurement
of change in welfare due to changes in the price level, China uses
the CPI as the major indicator to measure deflation. Second is the
scope of deflation. Western scholars usually consider inflation less
than 1 percent as deflation since governments have a tendency of overestimating
inflation by 1 percent. Third is the duration of deflation. It is
commonly believed that the criterion for deflation is a sustained
drop in the price level over two quarters.

According to the above criterion, China is experiencing mild deflation
since the change of CPI in China has been between -1 percent and 1
percent since 1998. It is well known that since 1998 the Chinese government
has paid a great deal of attention to deflation, fought deflation
through proactive fiscal policy and sound monetary policy and achieved
marked results. In the first half of 2003, credit and loans increased
greatly and money supply also grew rapidly. As a result, we not only
need to fight deflation, but also need to prevent inflation, maintain
a stable currency and provide a good monetary environment for economic
development.

Next, how to understand the coexistence of rapid growth of China economy
and deflation. After China successfully achieved a "soft landing"
in 1996, the annual growth rate has declined compared to past years
but remains between 7 percent and 8.2 percent. In a global setting
where most countries are facing deflation and depression, China's
economy still grows rapidly and has a promising future. But given
its exposure to the international economy, China cannot avoid worldwide
deflation. Thus high growth rates and deflation coexist. Rapid growth
in aggregate demand is the precondition of high growth in the economy.
But the existence of deflation means insufficient or declining demand.
The key to understanding this phenomenon is to understand total demand.
In China, proactive fiscal policy through investment and exports generates
rapid growth, but insufficient consumer demand results in deflation.

Our economic growth comes mainly from the rapid growth in investment
and exports. In the first half of 2002, total fixed investment was
RMB1.4462 trillion, which is a 21.5 percent increase over the same
period in 2001; the growth rate is 6.4 percent higher than same period
of 2001. And public and private investments both climbed: State-owned
investment in the first half of 2002 increased by 24.4 percent over
the same period of 2001; the growth rate was higher by 6.5 percent.
Urban and rural collective and individual investment increased by
17.8 percent over the same period of 2001, a trend rarely seen in
recent years. As for exports, in the first half of 2002, total exports
were US$142.1 billion, which was a 14.1 percent increase over the
same period of 2001; the growth rate increased by 5.4 percent.

In the first half of 2003, investments reached a new high. The accumulated
total investments accomplished were RMB1.9348 trillion, a 31 percent
increase over the same period last year; the growth rate was 9.6 percent
higher. Public investment was RMB1.5073 trillion, a 32.8 percent increase
over first half 2002, and private investment was RMB427.5 billion,
a 25.5 percent increase. Exports totaled US$190.3 billion in the first
half of 2003, a 34 percent increase.

The growth rate of consumption has slowed down. In the first half
of 2002, aggregate retail sales of consumption goods was RMB1.9959
trillion, an 8.6 percent increase in nominal terms over the same period
of 2001. In inflation-adjusted prices, the growth rate was 9.4 percent,
0.6 percent lower than the previous year. The slowdown of consumption
is mainly because income and expenditure expectations didn't improve.
The high pressure of unemployment and the expectation of higher future
expenses, especially due to the poor social security system, led to
more saving, less consumption and a fall in propensity to consume.
Also, worldwide and domestic agricultural prices have been falling
in recent years. Farmers have incurred losses of RMB350 billion, and
the growth rate of farm income per farmer has decreased continuously
for four years. In 2002, the growth rate was 4 percent. This has led
to sluggish rural consumer demand. In addition, the extensive spread
of SARS in the first half of this year also influenced consumer demand,
though the overall influence has been small.

Lastly, let's discuss the coexistence of high growth rate in money
supply and deflation: Traditional quantity theory argues that the
growth rate of money supply equals the sum of economic growth rate
and inflation. When the money supply growth rate is higher than the
economic growth rate, the difference is the inflation rate. But in
recent years in China, the growth rate of money supply has remained
around 14 percent to 15 percent, which is higher than the economic
growth rate of 7 percent. In the first half of this year, there is
deflation even though the money supply growth rate is 12 percent higher
than the economic growth rate.

We think the coexistence of high money supply growth rate and deflation
is the result of multiple factors:

since the time lag of monetary policy is quite long and the transmission
mechanism is uncertain, prices cannot quickly reflect changes in
money supply;

the monetization process increases money demand and absorbs the
increase in money supply;

because the time lag of the effects of M1 (money in the narrow
sense and the medium of exchange) on economic variables is quite
long-approximately nine to 13 quarters-current data cannot explain
the relation;

the rapid growth of money supply in the broad sense is mainly
because of fast growth of national savings, which reflects conservativeness
in consumption and increase in wealth. It is a result of narrow
investment channels and the downturn in capital markets, but not
closely related to current economic growth.

Fiscal Policy—Deficit Spending

Rolnick: For many years, the Chinese government
has financed its expenditures through deficit spending. The budget
presented to the National People's Congress in March 2003 projected
a 3.2 percent increase in the deficit, which will rise to US$38.6
billion, about 3 percent of GDP. That is a record deficit for China,
I believe, though the 2003 rise is modest compared with last year's
double-digit increase.

Are you concerned that such deficit spending might be unsustainable?
Is the government borrowing too much or can it afford to continue
building debt?

Xie: In 1998, China started to carry out a proactive
fiscal policy characterized by an increase in long-term construction
government bonds and investment in infrastructure and technology improvement.
Over the past five years, this proactive fiscal policy has achieved
clear results in promoting stable economic growth, speeding up adjustment
in the economic structure, improving the social security system, and
so on.

But over time, the negative effects of proactive fiscal policy have
emerged. In recent years, the deficit ratio and debt ratio have increased
markedly: From 1998 to 2002, the deficit-to-GDP ratio increased from
1.2 percent to 3 percent and the debt-to-GDP ratio increased from
11 percent to 18 percent. Furthermore, continued short-term countercyclical
practices will increase the government's direct intervention in the
economy, contrary to the objectives of market-based reform. All these
questions influence the sustainability of proactive fiscal policy
and the ability to implement agreed-upon macro adjustment objectives.

The necessity of maintaining proactive fiscal policy in recent years
The active fiscal policy was designed as a countermeasure to the slowdown
of the economy after the Asian financial crisis. The objectives are
to increase the economic growth rate and to provide a good environment
for economic reforms. Whether to continue this policy depends on the
following conditions: first, an improved international environment
and rapid growth in external demand; second, the systematic recovery
and prosperity of private investment and the formation of independent
growth mechanisms for domestic investment and consumer demand; and
third, the ratios of deficit and debt over GDP relative to warning
levels.

Looking at our current economic circumstances, it appears that the
international economy is recovering slowly but the outlook is still
uncertain. The formation of independent growth mechanisms of domestic
investment and consumer demand has been very slow and is currently
unable to replace government investment. Based on the economic situation
in 2002, external factors are apparently strong for economic growth,
depending mainly on rapid growth in investment and exports. The fast
growth of investment originates from government investment, while
growth in exports will be difficult in the future.

Moreover, required fiscal expenditures necessitate that we maintain
some level of debt: huge pressure on central government finances from
economic structural adjustments (the debt of state-owned enterprises
and bad loans, increase in social security spending); infrastructure
investment in projects to support development in western China; peak
periods of repaying debt and interest, etc. Currently, the ratio of
outstanding debt over GDP hasn't reached the international warning
line and the ratio of deficit over GDP is closing in on the warning
line but still leaves some room. Therefore, proactive fiscal policy
will continue to be implemented.

Feasibility of issuing debt
The fiscal deficit and scale of debt in China are both still within
internationally accepted guidelines. The debt ratios for 1998-2002
are 11 percent, 12.7 percent, 14.6 percent, 16.3 percent and 18 percent,
respectively, and obviously below the ratios of most developed countries.
The deficit ratio in 2002 reached 3 percent. But when compared to
the 1992-1995 recession period in the developed countries, the deficit
ratio in China is not high; when compared to the Eastern European
transition economies, it is low; and by overall international standards,
it is about average, or perhaps at a somewhat low level.

The overall scale of government debt in China is small and reasonable,
with quite a strong ability to repay debt and with no risk of default.
Since 1998, when the proactive fiscal policy was begun, the risk of
government debt has increased to some extent, but it is still under
control. Moreover, the major part of fiscal risk in China is from
bad assets in state-owned banks, gaps in the social insurance funds
and the implicit retirement debt of state-owned enterprises; [just]
a small part is from government debt. The overall debt risk to the
Chinese financial system is low. A suitable increase in national debt
will not impose too much additional burden.

In the medium and long run, there is still some room for issuing debt
in China and there are solid funding resources. First, the savings
rate in China is quite high, around 40 percent. The banks have sufficient
capital with a large margin between lending and deposit interest rates
and a low overall interest rate level.

Of course, while continuing to implement proactive fiscal policy,
we must strengthen risk awareness and risk prevention mechanisms;
be aware of the overall situation at the ground level; set reasonable
limits for deficit and debt issuance; properly adjust debt structure;
pay attention to the linkages between and coordination of countercyclical
short-term policies and medium- to long-run policies in order to sustain
growth and deepen reform; try to find time and opportunities to solve
deep systemic and structural problems; provide a good environment
for positive economic and financial cycles; and prepare for a new
round of rapid economic growth.

Future Growth Trends

Rolnick: Observers throughout the world have been
surprised and impressed by China's rapid economic growth, its remarkable
transformation from central planning to increased reliance on markets,
its growing openness to international trade and its quickly developing
infrastructure. Is there anything that would stand in the way of the
Chinese economy continuing to grow at this robust rate, or do you
foresee sustained economic expansion in coming decades?

Xie: In recent years, the Chinese economy has maintained
a high growth rate. Since 1998, the annual GDP growth rate has been
over 7 percent. And in 2003, the economy continues to grow rapidly.
In the first half of this year, GDP, fixed investment, consumption
and net exports grew at 8.2 percent, 31.1 percent, 8 percent and 39
percent, respectively. The growth rates of fixed investment and net
export were the highest seen in recent years.

The main reasons for China's rapid growth are the following:

The socialist market system laid a systematic foundation for
economic development.

Independent mechanisms for economic growth are gradually strengthening;
for example, private investment has become active since 2002 and
private investment as a percentage of total investment is increasing.

Our opening-up policy is very effective. Foreign direct investment
has increased rapidly: The growth rate in 2002 was 12.5 percent,
and in the first half of 2003 it was 34.3 percent.

Industries related to high technology and higher living standards,
such as housing, communications and the auto industry, have grown
rapidly and have become important factors in promoting economic
growth.

There is a massive supply of cheap labor in China.

There also exist several problems in China's economy. First, employment
pressure is high due to the contradiction between the huge population
and increasing labor productivity. Second, [personal] income grows
slowly, especially in rural areas, and this is incompatible with the
nation's high GDP growth rate. Third, the economy is still experiencing
insufficient demand—aggregate supply is greater than aggregate
demand. In addition, in some areas there still exist unwise investments
and redundant construction of low efficiency. And last, the growth
rate of the consumer price index has just become positive (-0.6 percent
in 2002 and 0.6 percent in the first half of 2003).

Over the next 10 years, China's economy will continue to grow rapidly;
the forecasted average annual growth rate of GDP is over 7 percent.
The reasons are as follows: First, the infrastructure to sustain Chinese
economic growth is becoming more solid, especially in transportation,
communication, irrigation works and energy. Also there has been progress
in industrial techniques, and science and technology innovation. Second,
China has big markets and great potential. Third, with continuing
inflow of foreign capital, China is becoming the international focus
for foreign investment. This will speed up structural adjustment in
industry and the renewal and upgrading of products. Fourth, with the
market system established, economic rigor and competitiveness are
increasing over time.

The National Savings Rate

Rolnick: As you noted, China's national savings
rate appears to be around 40 percent of GDP—very high relative
to most countries. Why is China's savings rate so high? Do you expect
it to come down in the near future?

Xie: China's national savings rate has been high
for many years and savings grow rapidly. Currently the national savings
rate is about 38 percent to 40 percent of GDP. The balance held on
deposit in financial institutions reached RMB10 trillion in June 2003.
The growth rate is above 18 percent.

There are four major reasons for the rapid growth of China's national
savings. First and most basic is the steadily increasing national
income. In recent years, the annual growth rate of GDP has been above
7 percent. Correspondingly, the national income also grows quite steadily:
Urban income grew at 9.2 percent in 2002 and 13.4 percent in 2003.
Though slower than urban income, rural income is also growing steadily.

Second, uncertainty about expected income and expenditures has increased
the propensity to save. Since China is transforming its systems of
income distribution, consumption, social security, prices, education,
finances, and so on, people must now begin to pay for many items that
used to be government welfare benefits. Therefore, many people are
reducing their current consumption and saving part of their income
at their bank to provide for future expenses.

Third, China has a long tradition of thrift. People usually purchase
big-ticket items, such as houses, cars and so on, through self-financing,
and this requires a long process of saving.

Fourth, limited opportunities for other types of personal investment
lead to the concentration of financial assets in savings accounts.
The stock market and other investments are risky. Particularly in
recent years, declines in the stock market have forced people to invest
conservatively. Other new investment tools have not become accepted
by or familiar to the public.

Rapid growth in national savings has bolstered the high growth rate
of China's economy. With rapid growth in savings, the growth rate
of investment is also sustained at a high level. In terms of overall
trends, high national saving is just a normal phenomenon in China's
process of transformation. In the future, national savings will continue
to grow rapidly.

But there are also a few problems with the high savings rate. For
example, in the financial structure, the proportion of loans financed
indirectly is too high and the proportion financed directly, through
stock and debt, for instance, is too low. This greatly increases the
risk and cost of bank loans and credit. Another problem: The fall
in propensity to consume dampens the effect of expansionary investment
to some extent and also affects the growth of consumer demand. We
therefore need to pay attention to these problems and consider measures
to raise efficiency in using savings resources and to create more
financing channels.

More specifically: (1) implement the social security system as soon
as possible to enhance the public's expectations; (2) expand current
consumption, reorganize markets and modernize products and promote
innovation as soon as possible; (3) broaden personal investment opportunities,
encourage financial innovation and provide more profitable investment
channels and products; (4) through faster development of direct financing,
speed the transition from savings deposits as the source of financing
to stocks, debt, funds and life insurance.

From the point of view of the PBOC, the contradiction between the
current high national savings rate and the difficulties faced by farmers
and small or medium-sized businesses in getting loans is significant.
This is a major issue that the financial system faces; it must be
studied seriously and solved. Since direct financing channels are
impeded, medium- and small-scale enterprise financing mainly depends
on bank loans. On the one hand, these firms have only a small capital
base, but have high debt. Banks lack incentive to make loans to them
due to risk considerations. On the other hand, savings deposits in
the banks are huge. To lend out their capital, banks have to lower
requirements on loans and thus they create new risks.

Hence, we must adopt comprehensive measures to solve the efficiency
problem in using savings deposit resources. More specifically: (1)
study how to induce banks to sell direct financing products (for example,
stock investment products) more actively; (2) learn from the developed
economies how to develop policies to encourage direct financing and
make investors feel that direct financing is better than savings deposits
in some respects; (3) in supervision policy, we must strictly execute
the capital adequacy requirements established by the Basel Accord.
Absorbing deposits and making loans will increase the amount of risky
assets in banks and require banks to have more capital. When banks
don't have sufficient capital assets, they will consider using other
financial products in which borrowers assume the risk (in particular,
direct financing products) instead of deposits. And (4) transform
financial products (including credit-derived products) into debt products,
including financial debt, that are accepted by the market.

Rolnick: Thank you very much.

Editor's note: We are grateful to Yan Bai and Jing Zhang, economics
graduate students at the University of Minnesota, for their careful
translation of this interview from Chinese.

* The June 2003 debt ratio of
22.19 percent is based on a different asset classification system
than the end of 2002 debt ratio of 21.41 percent mentioned in the
previous paragraph.

More about Ping Xie

Mr. Xie was born in the port city of Wenzhou in Zhejiang Province,
on China's east coast. he received his master's degree in economics
from China's Xinan University of Finance and Economics in 1984
and his doctorate in economics from Renmin University in 1988.

From 1985 to 1987, he worked as deputy division chief and then
chief in the Planning Department, Interest Rate Department and
Policy Research Department of the PBOC. From 1994 to 1997 he
was deputy director of the Policy Research Department and director
of the Non-bank Financial Institutions Department. He became
governor of of the Hunan Branch of the PBOC in November 1997,
but several months later was appointed as director-general of
the PBOC's Research Department and made a PBOC Senior Research
Fellow.

Xie's economic research has won a number of prestigious academic
awards in China, including the Sun YeFang Economic Science award
and the Society for Finance and Banking excellence award. He
is chief editor of the Journal of Financial Research, senior
research fellow of the Financial Study Centre of the China Academy
of Social Science, and professor at Xinan University of Finance
and Economics, Nan Kai University and Renmin University.